Who dares punt on China and resources

Global stocks have had a great run in recent months, though with the US market appearing overbought in at least the short run, markets have been looking for excuses to undergo a cleansing correction.

America’s S&P 500 Index is already up almost 10 per cent for 2013, but the market’s weekly relative strength index – a measure of over-bought and oversold conditions – has been pushing above warning levels of 70 for the past few weeks.

In a strongly up-trending market, that does not necessarily indicate a sharp pullback is coming, but it does suggest the market may dawdle for a bit and be sensitive to negative news.

Over the past week, we’ve had several potential negative triggers, including the Boston Marathon bombing, North Korean sabre rattling, new worries over US corporate earnings, softer-than-expected Chinese economic growth and a global growth downgrade by the International Monetary Fund.

All up, the US market held up well. After a recent closing peak of 1593 points on Thursday, April 11, the S&P 500 midway through this week had eased by only about 3 per cent. A good market correction – as evidenced twice last year – usually involves price falls of about 10 per cent.

Most of the present market worries don’t appear too serious. For starters, no one really believes North Korea will be silly enough to attack South Korea or the United States. And after some initial fears, the Boston bombing (albeit tragic for those involved) appears a limited and isolated incident, rather than part of a broader attack across the United States.

US corporate earnings reports are waxing and waning, but the economy is still recovering with unemployment falling. Even with the IMF downgrade, global growth is expected to be close to average this year – roughly 3.3 per cent. Of course, Europe still has the capacity to surprise global markets – but the backstop of European Central Bank financing for the key economies of Spain and Italy has calmed nerves.

As is the way with markets, however, another pullback of at least 10 per cent or so for the US market seems likely at least once this year – though knowing exactly when and why is more difficult to discern. And when Wall Street pulls back, our market is usually not far behind.

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Indeed, after outperforming in the seven months ending in February, our market underperformed the US market during March, due to renewed fears about the Chinese economy and global commodity prices. China fears have recently reappeared – and while they’re unlikely in themselves to derail the global equity rally, they spell near-term trouble for the fledgling recovery in local resource stocks and the Chinese sharemarket.

To contain a frothy property market and inflation pressure, China has tightened policy and engineered a slowing in the economy over the past two years – at the cost of making its sharemarket one of the worst performing in the world and weighing down local resource stocks.

But the slowdown appeared to be over by late last year, as China announced modest measures to encourage infrastructure and low-cost housing. Annual Chinese economic growth ticked up to 7.9 per cent in the December quarter, the first acceleration in growth since late 2010.

Such optimism appears a little premature. This past week, data revealed annual Chinese economic growth slowed to 7.7 per cent in the March quarter – less than the 8 per cent expected by the market. Much to the consternation of commodity bulls, Chinese leaders seem untroubled by the economy slowing a bit further due to continued strong growth in credit and hard-to-contain property fervour.

But markets have noticed. Since late February, both the Chinese sharemarket and local resource stocks have pulled back – the former by 10 per cent and the latter by a much more serious 25 per cent.

Indeed, all of the encouraging recovery in the S&P/ASX 300 Metals and Mining Index from mid-2012 has been unwound since late February, and technically there’s now no natural support level until the lows of late 2008. The Shanghai Composite Index is still holding on to about half its gains since mid-2012, but it’s less clear whether the market has ended its multi-year bear market slump.

As I’ve argued in recent months, the Chinese market appears cheap, and has become even cheaper, with a price-to-forward earnings ratio of only 9, or 25 per cent below its long-run average of 12. Trend Chinese forward earnings growth has been about 15 per cent over the past decade. Provided Chinese growth can keep chugging along – the official growth target is 7.5 per cent – the likely medium-term returns from the market appear good.

This is probably also the case for resource stocks, with analysts pencilling in a near 30 per cent rise in earnings in the coming financial year.

But with the news flow turning negative again, buying China and resource stocks at present is a bit like catching a falling knife.